Wednesday, November 19, 2008

Debt market under pressure - WSJ

A record drop in the overall U.S. producer-price index added to deflation worries Tuesday, hammering the prices of inflation-protected securities.
The 10-year break-even rate, the yield gap between the 10-year Treasury inflation-protected securities and 10-year nominal Treasurys, dropped 0.21 percentage point to 0.55 point, the lowest level since the Treasury Department started to sell TIPS in 1997.
The gap suggests investors now expect an average annualized inflation of 0.55% over the next decade, highlighting the magnitude of the change in the past few months from inflation concern to deflation worries. Oil prices have dropped more than 50% from a record high set in early July, and the financial crisis that has fueled recession fears strengthened the conviction among investors that falling, not rising, prices are the major concern right now.
"It isn't unreasonable to think that year-over-year headline inflation will see a couple of negative prints sometimes in the first half of next year," said Wan-Chong Kung, who helps oversee $36 billion in fixed income at FAF Advisors in Minneapolis. "There is no question that the TIPS market is pricing in a much more pessimistic view on inflation."
Investors already are pricing in deflation in five years. The five-year break-even rate stood at a negative 0.67 point Tuesday -- implying inflation of -0.67% in the next five years -- as five-year TIPS yield more than five-year nominal Treasury notes. TIPS typically yield less than nominals as their principal is adjusted periodically to reflect changes in consumer prices. (check ILBE bloomberg command)
"The market is becoming concerned about upcoming inflation prints, particularly with the headline PPI number coming in much lower than expected," said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc.
Wednesday sees the release of October consumer-price data, which could be much softer than the expected 0.8% monthly decline. Some strategists and economists have said they expect headline inflation to drop below zero by the first half of next year.
TIPS, along with their counterparts in the euro zone, the U.K. and Japan, have been hammered in recent months as the financial crisis triggered a global wave of selling across a wide range of asset classes, from stocks to emerging-market bonds and commodities. Rising deflation concerns have contributed to the selling as TIPS are less attractive in a falling price environment.
At the same time, nominal, or cash, Treasurys have been buoyed by safe-haven buying, causing their yields to fall just as TIPS yields are rising. Bond yields move inversely to prices.
"Conventional Treasuries are currently favored over inflation-indexed Treasuries because conventional Treasuries are more liquid," said Miller Tabak strategist Tony Crescenzi.
Tuesday, the benchmark 10-year note rose 1 8/32 points, or $12.50 for every $1,000 invested, to yield 3.537%, on the back of the soft producer-price data, as well as more bad news on housing.